Sunday, June 1, 2014


June 2014

The structure of the economy – particular industries’ relative shares of GDP and total employment, but also the age, gender and full-time/part-time structure of the labour force, and the role and relative size of government – is always changing. It’s always changing because the forces for change bearing down on the economy keep changing. But those forces seem particularly numerous and strong at present.

So I want to talk about those structural changes, about how the government is responding to them with its economic policy, and about the prospects for the economy, particularly employment.

Sources of structural change

Among the many sources of structural change affecting the Australian economy, the two biggest and most general are globalisation and technological advance. Globalisation is the process by which the natural and man-made barriers between national economies are being broken down, partly by deregulation but mainly by advances in technology.

One part of globalisation is the rapid economic development of Asia, which is increasing our access to cheaper imports of manufactures, from clothing to electronic goods and cars, but also increasing the demand for our exports of minerals and energy. The growth of Asia’s middle class will increase demand for tourism, westernised foodstuffs and niche manufactured items.

The internet, the advent of e-commerce and the digital revolution are beginning to have big effects on industries such as recorded music, cinema, book selling and publishing, the post office and the retail sector generally, not to mention newspapers and the rest of the news media, and the advertising industry.

Households went through a protracted adjustment to financial deregulation – which greatly increased the availability of credit – and the return to low inflation in the early 1990s, which significantly reduced nominal interest rates, prompting a housing boom and leading households to greatly increase their housing debt, reducing the household saving rate to zero. But this untypical behaviour couldn’t go on forever. It started to end before the global financial crisis, but continued in earnest after it, with the household saving ratio returning to 10 per cent, where it seems to have settled.

Demographic change – the decline in fertility and the retirement of the baby-boomer bulge – is changing the economy’s ratio of workers to dependents, making a slower rate of growth over the next 40 years more likely as the participation rate falls for demographic reasons and highlighting the need to make the labour market more female-friendly and older worker-friendly.

Another structural change is climate change. The Labor government responded to this by introducing a carbon tax that was to turn into an emissions trading scheme in July this year. It bolstered this by raising the Howard government’s renewable energy target to ensure that 20 pc of Australia’s electricity comes from renewable sources by 2020. However, the Abbott government, which includes many climate change deniers, is seeking to abolish the carbon tax and replace it with ‘direct action’ in which businesses are offered incentives to reduce emissions. The renewable energy target is being reviewed by an avowed climate change ‘sceptic’.

The resources boom, stage III

But the biggest and most immediate structural change affecting both the structure of the economy and its year-to-year macroeconomic management is the resources boom, itself a product of globalisation and the rapid economic development of Asia, particularly China.

The resources boom began in 2003 and was divided into two parts by the global financial crisis of 2008-09. The boom has had three stages: first, much higher prices for our exports of coal and iron ore, causing our terms of trade to reach their best for 200 years. Second, a historic surge of investment spending to greatly expand our capacity to mine coal and iron ore and extract natural gas. And third, a considerable increase in the volume (quantity) of our production and export of minerals and energy.

The first stage is now over, with coal and iron ore prices reaching a peak in mid-2011 and the terms of trade falling about 20 pc since then. Now the second stage, the growth in mining investment spending, has reached a peak and begun to decline, making a negative contribution to growth. This is being only partly offset by the commencement of the third stage of the boom, the rising volume of mineral and energy exports as the newly installed production capacity comes on line.

The boom has greatly expanded our mining sector, taking its share of total production (GDP) from 4 pc to about 10 pc, although the industry is so highly capital-intensive its share of total employment is still only about 2 pc. The industry has been, and remains, highly profitable. Since its direct contribution to the employment of Australians is so small and since the industry is about 80 pc foreign-owned, it is important that it contribute to the economy by having its economic rent adequately taxed. The Labor government responded with a minerals resource rent tax, but mishandled its introduction, allowing the three main companies paying it to minimise their payments in the early years by getting generous tax deductions up-front. The Abbott government is seeking to abolish the tax.

The rapid expansion of the mining sector has required the transfer of labour and capital from elsewhere in the economy, a process of structural adjustment which the high dollar, brought about by the marked improvement in our terms of trade, has helped to facilitate by exerting painful contractionary pressure on our other tradeable industries, particularly manufacturing.

In its early stages, the boom presented the macro managers with the challenge of ensuring the jump in our real national income brought about by the high export prices didn’t lead to an inflation blowout as had happened with previous commodity booms. This possibility was avoided, particularly because our floating exchange-rate regime allowed a big rise in the dollar, which constrained our other tradeable industries, reduced inflation directly by lowering import prices and directed excess consumer demand into imports.

In the later stages of the boom, however, the macro managers now face roughly the opposite challenge: ensuring the fall in national income as export prices fall back, and the pipeline of mining and natural gas investment projects starts to empty, don’t cause the economy’s growth to slow too far and lead to a big rise in unemployment.

The need for the economy to make a ‘transition’ from mining-led growth to growth led by other industries and other categories of demand has been preoccupying the macro managers for at least a year and is likely to be their main focus of attention for at least another year. The falloff in mining investment spending is expected to subtract significantly from domestic demand in the coming financial year, 2014-15, and the following year. The need to encourage growth in the non-mining economy has so far been made more necessary and more difficult by the failure of the dollar to fall by as much as the fall in mining export prices and deterioration in our terms of trade had led us to expect. The dollar did fall back after April 2013, but in more recent times has been surprisingly strong, possibly because of the continuing ‘quantitative easing’ in the United States and elsewhere.

The continuing preoccupation with successfully negotiating the transition from mining-led to broader-based growth is the dominant consideration in the settings of both monetary policy and fiscal policy.

Monetary policy

Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. It is the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. MP is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over the cycle. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.

After the GFC reach its height in late 2008, the RBA feared we would be caught up in the Great Recession that hit other economies, so it quickly slashed the cash rate from 7.25 pc to 3 pc. By October 2009, however, it realised we would escape the recession, so began lifting the cash rate from its emergency level, reaching 4.75 pc in November 2010.

In November 2011, the RBA decided the resources boom was easing and would not push up inflation. It realised growth in the non-mining sector of the economy was weak - held down particularly by the dollar’s failure to fall back in line with the fall in export prices – at a time when mining-driven growth was about to weaken. So it began cutting the cash rate, getting it down to a historic low of 2.5 pc by August 2013.

The RBA is trying to counteract the dampening effect of the high dollar by using lower interest rate to stimulate demand in other parts of the economy, particularly housing and consumption, but also non-mining business investment. It is having some success with housing investment, but not much with consumer spending and none with business investment. Barring a sharp fall in the dollar, it’s likely to keep interest rates low until it is confident the economy has made the transition to broad-based growth successfully.

Fiscal policy

Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Abbott government’s medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. This means the primary role of discretionary fiscal policy is to achieve ‘fiscal sustainability’ - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand, in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.

The Labor government proved unable to keep its promise to get the budget back to surplus in 2012-13, not because it was spending too much (though it did have big plans for increased spending in the second half of the 2010s), but because the sharp falls in mineral export prices slowed the growth in nominal GDP and so caused the recovery in tax collections to be far weaker than expected.

Mr Hockey’s first budget included many cuts in government spending, big increases in user charges for GP visits, pharmaceuticals and university education, a shift from indexing payments and benefits to wages to indexing them to prices, a return to indexing the fuel excise and a temporary deficit levy on high income-earners.

The budget deficit is expected to fall from $50 bil in the financial year just ending to $30 bil in the coming year, 2014-15, then to $17 bil the following year and $3 bil in 2017-18. The budget’s 10-year ‘medium-term projection’ shows it returning to a balanced budget in 2018-19, then with a surplus growing each year until it reaches 1.5 pc of GDP in 2024-25.

From a fiscal policy perspective the budget has two key features: 1) A slow pace of fiscal consolidation. The budget’s new measures and revisions to forecasts are expected to improve the budget balance by just $4 bil in the budget year and by $7 bil in each of the following two years, but by $26 bil in 2017-18. This slow start is intended to avoid the budget having a dampening effect on growth while the economy is expected to be growing at a below-trend rate.

2) A switch in the composition of government spending. While spending on transfer payments leading to consumption is reduced, spending on infrastructure investment is increased by $12 bil. About half this is spent on an ‘asset recycling initiative’ intended to encourage the states to increase their own infrastructure spending. The goal is to help fill the vacuum left by the fall in mining investment.

All this means the ‘stance’ of fiscal policy adopted in the budget is contractionary, but only to the most minor extent. The government knows the economy will be hit by big cuts in mining investment spending over the next two years, and so is delaying its plans to return the budget to surplus.

The outlook for growth and employment

The government is expecting the economy to grow by 2.75 pc in the present financial year, slowing to 2.5 pc in the coming year, but rising to 3 pc in 2015-16 and 3.5 pc in the following two years.

The economy’s medium-term trend rate of growth is 3 pc. This is consistent with growth in employment of 1.5 pc a year and the rate of unemployment at its lowest sustainable rate (the NAIRU) of 5 pc.

So below-trend growth this financial year and next is expected to see unemployment creep up to 6.25 per cent by June 2015, and stay high until it returns to 5.75 pc by June 2018.